Regional growth seems likely to continue, despite high energy prices, and with improving risk-management standards, prospects appear
The nascent Year of the Fire Dog under the Chinese lunar calendar may just be a favorable one for the Asian banking sector. Favorable environmental and operational factors indicate that the outlook remains bright going into 2006. Nonetheless, bank management teams still need to sink their teeth into outstanding issues to prepare for unexpected shocks and the inevitable future cyclical downturn.
Still-strong (albeit slowing) regional GDP growth, improving asset quality, stable and increasingly diverse earnings, and increased management emphasis on risk controls support the banks' improved credit profiles.
To a certain degree, Standard & Poor's Ratings Services had factored these improvements and expectations into its upgrade on bank ratings in 2005. Outstanding issues in the banks' environment include inherent volatility of economies in which the banks operate and, in some systems, governance concerns in the commercial, political, and legal arenas. These factors imply that Asian banking systems continue to face moderately low to very high economic and industry risks. Not surprisingly, there are some dark clouds in the distance -- these take the form of weaker U.S. consumer demand, relatively high oil prices, emerging bottlenecks in some parts of China's infrastructure, and the uncertain effects of the spread of avian flu, and more importantly public fear about the disease.
Standard & Poor's outlook for the Asian banking systems for 2006 can be summarized as follows:
- Asset-quality indicators will continue to improve for all Asian systems in 2006, but at a pace slower than in 2005. The low-hanging fruits in the nonperforming asset (NPA) pools have been plucked and further reduction in NPA would come from resolution of the relatively more hard-core NPAs.
- Profitability of Asian banking systems will be sustained largely at current levels, supported by structural improvement in the income profile.
- The strengthening of risk-management practices at Asian banks will pick up in pace.
- Merger and acquisition (M&A) activity will gather some steam in 2006 but remain slow as there is no serious visible push from governments as yet.
- GDP growth for many Asian economies is likely to remain strong in 2006, despite a slight easing from 2005. In the medium term, a slowing trend is expected. Global macroeconomic conditions, including growth, liquidity, and interest rates, are still favorable for the region's economies.
Inflationary pressures persist, with oil prices only moderating from record highs, even as more oil bears have emerged. Global liquidity, while still ample, is tightening. Asian central banks are playing catch-up with the U.S. Federal Reserve and the pace of interest-rate hikes could quicken in 2006 ahead of a likely end in U.S. policy tightening in June.
Interest-rate increases are thus expected to affect the housing and asset prices in Asian markets, although a major downturn in most real estate markets appears unlikely. The U.S. housing market could be more severely affected by the higher Federal Reserve rate, moderating consumption and thus exports from Asia.
Corporate restructuring -- partly in response to competition from China -- across Asia has streamlined operations and increased capacity utilization as well as capital expenditures. There are also some signs of diversification away from China by U.S. and European investors. Rising interest rates have had greater impact on consumers (from higher mortgages payment) than on corporate investment plans and credit profiles in Asia due partly to strong corporate earnings. Corporate indebtedness is generally low to modest, except for Philippines and, to an extent, Indonesia.
A more severe outbreak of Avian flu could reduce global GDP by 1% even if the situation does escalate into a pandemic, according to the World Bank. National health authorities have thus far contained the flu to a very small number of geographic locations.
The most immediate uncertainty is inflation and the use of monetary policy (including exchange-rate adjustments) to maintain price stability. Policy responses will inevitably have an impact on the quality of longer-term growth. Strong credit growth and big capital inflows in some economies can complicate monetary policy management.
Negative real rates, for instance, are still prevalent in some economies. The scenario assumes that adjustments in the financial imbalances between the U.S. and the world in terms of currency and interest rates will be gradual.
Asian countries have largely recovered from the 1997-98 financial crisis, but are vulnerable to the above-mentioned risks. A close look at the state of Asian banking systems should provide a better assessment of their vulnerability to these risks.
Asset quality indicators have continued to improve over the past few years due to write-offs/provisions, recovery from the stock of NPAs—by way of actual recovery or sale to an asset reconstruction/management company—and better quality of incremental credit. Improved economic conditions have been an important supportive factor.
Loan loss reserves are improving. The average loan loss reserves to NPA ratio is above 40% in most Asian banking systems, except China and Taiwan. Loan loss reserves have improved only for a few banking systems, as most banks have used existing provisions to write off the loans.
A few systems still have significant vulnerability in their credit portfolios. Of these, a few like China and Indonesia have seen their credit portfolios grow rapidly. While the growth will spread the risk and provide earning streams to help tackle past delinquencies, it will put pressure on still-evolving risk-containment systems.
In this context, corporate sector credit quality and consumer indebtedness are key risks. India and China are reasonably comfortable on this count, but the Philippines and, to an extent, Indonesia are not. Hence, continued credit growth can help accelerate the trend of improving asset quality for the Chinese, Indian and, perhaps, Indonesian banking systems. The expected slower pace of growth in 2006 would retard the improvement but is unlikely to reverse the trend.
In conclusion, asset quality indicators have vastly improved from four to five years ago. As the low-hanging fruits in the NPA pools have already been plucked, further reduction in NPA would come from resolution of the relatively more hard-core NPAs. Given structural constraints in and challenges faced by the developing economies during the growth phase, the indicators for most Asian banking systems are unlikely to match those of developed systems over the medium term. Standard & Poor's expects asset quality indicators to continue to improve for all Asian systems in 2006 but at a pace slower than in 2005.
Earnings: Stable, More Diversified
The profitability of the Asian banks, as measured by net interest income to average adjusted assets, has largely remained stable in the 2%-3% range, even through the rising interest-rate regime in 2004 and 2005.
PRESSURE ON MARGINS.
Most of the Indonesian banks rated by Standard & Poor's had higher interest margins, exceeding 5%, in 2004 due to a higher level of intermediation. Competitive forces and steeply rising policy rates in Indonesia are expected to cause the interest margin to decline to a more sustainable 3%-4% range.
Variable-rate loans form the lion's share of Asian banks' portfolio. Due to the dominance of shorter-tenure fixed-rate deposits, these liabilities are akin to variable-rate liabilities. Hence, a bank's pricing power determines the impact of rising interest rates, rather than the structure of the balance sheet per se. Except for Singapore and Hong Kong whose markets are dominated by a few big banks, most of the region's banks will experience interest-margin pressure.
To maintain profitability, banks in these competitive markets will target consumer and small to midsize business lending, fee income, and improvement in efficiency and economies of scale. Diversification of the earnings profile, including the focus on noninterest income, has continued. The outlook for growth of noninterest income is bright due to the low penetration of insurance, mutual funds and retail credit businesses, and continued recovery in most economies.
Banks have continued to grow their nonbanking businesses organically as well as inorganically in domestic and overseas markets in a bid to diversify their income. This process is especially visible in Indonesia and Malaysia. Some banks have, however, chosen to tie up with finance companies with good retail franchises.
Although Singapore and Hong Kong banks' interest margins are significantly lower than the 3% rate of most Asian banks, their return on average assets is better at well above 1%. This is due to a higher proportion of noninterest income, better operating efficiency, and low credit costs.
In 2006, we expect the profitability of Asian banking systems to be largely sustained at current levels. The structural improvement in the income profile due to a significant consumer loan book and increasing share of noninterest income should help these systems weather a slight economic slowdown.
Risk Management: Center Stage
The risk-management systems of Asian banks are in various stages of evolution. The Singapore and Hong Kong banks are the most sophisticated, given the developed markets they operate in. After recovering from severe credit losses during the Asian financial crisis, banks are strengthening their risk-management systems.
With the proportion of mandated lending significantly reduced, banks need to develop the capability to originate healthy loans and monitor their portfolios. Gradual improvement in prudential lending norms in line with international standards and the impending implementation of Basel II capital adequacy framework add to the urgency of establishing sound risk-management systems. While this trend is common across all emerging markets, Taiwanese, Malaysian, Indian, and Thai banks are moving further ahead than their regional peers.
In general, the risk-management systems have come a long way. While there is scope for further strengthening, existing systems should partly shield leading banks from the adverse effects of an expected economic slowdown in 2006. We also expect banks to step up the pace in strengthening their risk-management practices.
Another trend is industry consolidation, which has been led or enabled by governments. The speed and effectiveness of consolidation have been mixed, reflecting each country's resolve in achieving its goals.
A less-fragmented banking system tends to be more robust and easier to supervise. Through consolidation, banks are able improve their competitiveness by exploiting synergies and achieving economies of scale. In general, the long-term aim is to have fewer but stronger national banks. While market pressure can also drive consolidation, most emerging Asian banking systems are dominated by government-owned banks and hence market forces alone are insufficient to spur change.
PICKING UP STEAM
While Malaysia saw a rapid and decisive first phase of consolidation and has embarked on the next phase, Taiwan, India, and Thailand still have a long way to go in this direction -- and the clock is ticking. By 2009, their banking systems will open up to foreign banks. Through mergers, domestic banks in fragmented markets like Taiwan, India, and Thailand can take advantage of synergies and economies of scale and thus become better prepared to compete in a liberalized banking environment. Only healthy and efficient domestic banks that have strong business and financial profiles will be ready to meet the competition from established global players.
In 2005, M&A activity was relatively subdued, with transactions mostly involving the acquisition of strategic stakes, rather than majority control. Even though there is little debate on the need for speedy consolidation, the pace of M&A activity in 2006 will be driven by respective governments. In our opinion, bank M&A will gather some steam in 2006 but remain slow as there is no serious visible push from governments as yet.
BusinessWeek & Standard & Poor's Ratings Services